No Slide Title · capital investment analysis. 2. Evaluate capital investment proposals using the average rate of return and cash payback methods. 3. Evaluate capital investment proposals

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

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Capital Investment Analysis

Chapter 25



Learning Objectives

1. Explain the nature and importance of

capital investment analysis.

2. Evaluate capital investment proposals using

the average rate of return and cash

payback methods.

3. Evaluate capital investment proposals using

the net present value and internal rate of

return methods.

4. List and describe factors that complicate

capital investment analysis.



Learning Objectives

5. Diagram the capital rationing process.



Learning Objective 1

Explain the nature

and importance of

capital investment

analysis.



Nature of Capital Investment Analysis

Capital investment analysis (or capital

budgeting) is the process by which

management plans, evaluates, and

controls investments in fixed assets.

LO 1




Methods that do not use present values

Average rate of return method

Cash payback method

Methods that use present values

Net present value method

Internal rate of return method

LO 1




LO 1




The time value of money concept

recognizes that a dollar today is worth more

than a dollar tomorrow because today’s

dollar can earn interest.

LO 1




Evaluate capital

investment proposals

using the average rate

of return and cash

payback methods.



Average Rate of Return Method

The average rate of return, sometimes

called the accounting rate of return,

measures the average income as a percent

of the average investment. The average

rate of return is computed as follows:

Average Rate

of Return

Estimated Average Annual Income

Average Investment =

(Initial Cost + Residual Value)/2

LO 2




LO 2

Machine cost $500,000

Residual value 0

Estimated total income from machine 200,000

Expected useful life 4 years

Average Rate

of Return

Estimated Average Annual Income

Average Investment =

Management is evaluating the purchase of a new

machine as follows:

Average Rate

of Return $200,000/4

($500,000 + $0)/2 = = 20%




The average rate of return of 20% should be

compared to the minimum rate of return required

by management. If the average rate of return

equals or exceeds the minimum rate, the machine

should be purchased or considered for further

analysis.

LO 2




The average rate of return has the following

three advantages:

1. It is easy to compute.

2. It includes the entire amount of income

earned over the life of the proposal.

3. It emphasizes accounting income.

LO 2



The average rate of return has the following

two disadvantages:

1. It does not directly consider the expected

cash flows from the proposal.

2. It does not directly consider the timing of the expected cash flows.


LO 2



EE 25-1



Cash Payback Method

The expected period of time that will pass

between the date of an investment and the

complete recovery in cash of the amount

invested is the cash payback period.

LO 2



Cash Payback Method

When annual net cash inflows are equal,

the cash payback period is computed as

follows:

Cash

Payback

Period

Initial Cost

Annual Net Cash Inflow

=

LO 2



Cash Payback Method

LO 2

Cost of new machine $200,000

Cash revenue from machine per year 50,000

Expenses of machine per year 30,000

Depreciation per year 20,000

Net cash inflow per year:

Cash revenue from machine $50,000

Less cash expenses of machine:

Expenses of machine $30,000

Less depreciation 20,000 10,000

Net cash inflow per year $40,000

(continued)



Cash Payback Method

LO 2

= 5 years Cash

Payback

Period

$200,000

$40,000 =

Cash

Payback

Period

Initial Cost

Annual Net Cash Inflow

=

The time required for the net cash inflow to equal

the cost of the new machine is the payback period.

The estimated cash payback period for the

investment in the machine is five years, as

computed below.



Cash Payback Method

LO 2

Assume that a proposed investment has an initial cost

of $400,000. The annual and cumulative net cash

inflows over the proposal’s six-year life are as follows:



The cash payback method has the

following two advantages:

1. It is simple to use and understand.

2. It analyzes cash flows.

Cash Payback Method

LO 2



Cash Payback Method

LO 2

The cash payback method has the

following two disadvantages:

1. It ignores cash flows occurring after the

payback period.

2. It does not use present value concepts in valuing cash flows occurring in different

periods.



EE 25-2




Evaluate capital

investment proposals

using the net present

value and internal

rate of return

methods.



Present Value Concepts

Both the net present value and the internal

rate of return methods use the following two

present value concepts:

Present value of an amount

Present value of an annuity

LO 3



Present Value of an Amount

LO 3

If you had $1 to invest for three years at 12%, how

much would you have after one year? By the end

of the second year? By the end of the third year?

$1 x 1.12 = $1.12 $1.12 x 1.12 = $1.254

$1.254 x 1.12 = $1.404



This process of interest earning interest is

called compounding. The illustration below

demonstrates the concept of

compounding.


LO 3




On January 1, 2012, what is the present value of

$1.404 to be received on December 31, 2014

(assuming an interest rate of 12 percent)? To

determine the answer, we need to go to Exhibit

1 (next slide) and find the table value for three

years at 12 percent.

LO 3

Using the PV of $1 Table




LO 3

0.712 × $1.404 = $1.00




LO 3

Another way of stating this is that the present

value of $1.404 to be received in three years

using a compound interest rate of 12% is $1, as

shown below.



Present Value of an Annuity

An annuity is a series of equal net cash

flows at fixed time intervals.

The present value of an annuity is the

amount of cash needed today to yield a

series of equal net cash flows at fixed time intervals in the future.

LO 3




LO 3

The present value of a $100 annuity for five periods

at 12% could be determined by using the present

value factors in Exhibit 1. This is shown graphically

in the next slide.

Left-click your mouse on the button to go to Exhibit 1.

Type “32” and press “Enter” to return to this slide.




LO 3




LO 3

Using a present value of an annuity of $1 table,

such as the one in Exhibit 2 (next slide), is a

simpler approach.

Using the PV of an Annuity of $1 Table




LO 3

3.605 × $100 = $360.50



Net Present Value Method

The net present value method compares

the amount to be invested with the present

value of the net cash inflows. It is sometimes

called the discounted cash flow method.

LO 3



Assume the following data for a

proposed investment in new equipment:

Cost of new equipment $200,000 Expected useful life 5 years Minimum desired rate of return 10% Expected cash flows to be received each year: Year 1 $70,000 Year 2 60,000 Year 3 50,000 Year 4 40,000 Year 5 40,000 Total expected cash flows $260,000


LO 3




LO 3

Using the present value of $1 (Exhibit 1) at 10%,

the present value of the net cash flow for each year

is shown below.

Left-click your mouse on the button to go to Exhibit 1.

Type “38” and press “Enter” to return to this slide.




LO 3

The preceding computations are also graphically

illustrated below.




LO 3

The net present value of $2,900 indicates that the

purchase of the new equipment is expected to

recover the investment and provide more than the

minimum rate of return of 10%.



Capital investment proposals can be

ranked by using a present value index. The

present value index is computed as follows:


LO 3

Present Value Index =

Total Present Value

of Net Cash Flow

Amount to Be

Invested




LO 3

The present value index for the investment in the

preceding slides is 1.0145, as computed below.

Present Value Index =

Total Present Value

of Net Cash Flow

Amount to Be

Invested

Present Value Index = $202,900

$200,000 = 1.0145




LO 3

A company is considering three proposals. The net

present value and the present value index for each

proposal are as follows:

Most desirable proposal



The net present value method has the

following three advantages:

1. It considers the cash flows of the

investment.

2. It considers the time value of money.

3. It can rank equal lived projects using the

present value index.


LO 3



The net present value method has the


1. It has more complex computations than

methods that don’t use present value.

2. It assumes the cash flows can be reinvested at the minimum desired rate of return,

which may not be valid.


LO 3



EE 25-3

Left-click on the button with your mouse to go to Exhibit

2. Type “46” and press “Enter” to return to this slide.



Internal Rate of Return Method

The internal rate of return (IRR) method uses

present value concepts to compute the rate

of return from a capital investment proposal

based on its expected net cash flows.

This method, sometimes called the time-

adjusted rate of return method, starts with

the proposal’s net cash flows and works

backward to estimate the proposal’s

expected rate of return.

LO 3




LO 3

Management is evaluating the following

proposal to purchase new equipment:

Cost of new equipment………………… $33,530

Yearly expected cash flows to be

received…………………………………. 10,000

Expected life……………………………… 5 years

Minimum desired rate of return……….. 12%




LO 3

The present value of the net cash flows,

using the present value of an annuity

table (Exhibit 2), is $2,520, as shown

below in Exhibit 3.






LO 3

Through trial and error, the rate of return

equating the $33,530 cost of the investment with

the present value of the net cash flows can be

determined to be 15%, as shown on the next

slide.




LO 3




LO 3

A trial-and-error procedure is time-consuming. To

illustrate a simpler procedure, assume that

management is considering a proposal to acquire

equipment costing $97,360. The equipment is

expected to provide equal annual net cash flows of

$20,000 for seven years.




LO 3

STEP 1: Determine the present value factor

for an annuity of $1 as follows:

$97,360

$20,000 = 4.868

Amount to be Invested

Equal Annual Net Cash Flows

(continued)




LO 3

STEP 2: Find the seven-year line on

Exhibit 2 (the present value of

an annuity of $1 at compound

interest). Proceed horizontally

across the table until you find

the present value factor

computed in Step 1 (or the

closest present value factor).

(continued)



3.605


LO 3

(continued)



STEP 3: Now that you have located

4.868 on the seven-year line,

go vertically to the top of the

table to determine the interest

rate.


LO 3

(continued)



3.605


LO 3

The minimum acceptable

rate of return is 10%. (concluded)




LO 3

The internal rate of return method has the

following three advantages:

1. It considers the cash flows of the

investment.

2. It considers the time value of money.

3. It ranks proposals based upon the cash

flows over their complete useful life, even if

the project lives are not the same.



The internal rate of return method has the


1. It has complex computations, requiring a

computer if the periodic cash flows are not

equal (an annuity).

2. It assumes the cash received from a

proposal can be reinvested at the internal

rate of return, which may not be valid.

LO 3




EE 25-4






List and describe

factors that complicate

capital investment

analysis.



Factors That Complicate Capital Investment Analysis

Income tax

Proposals with unequal lives

Leasing versus purchasing

Uncertainty

Changes in price levels

Qualitative factors

LO 4



Income Tax

For federal income tax purposes,

depreciation on fixed assets can be much

shorter than the actual useful lives. Also,

depreciation for tax purposes often differs

from depreciation for financial statement

purposes.

LO 4



Unequal Proposal Lives

Assume that a company is considering purchasing

a new truck or a new computer network. The data

for each proposal are shown below.

LO 4




LO 4

(continued)



LO 4




EE 25-5

Left-click on the green button with your mouse to go to Exhibit 1 and red

button to go to Exhibit 2. Type “67” and press “Enter” to return to this slide.



Lease versus Capital Investment

Some advantages of leasing a fixed asset

include the following:

The company has use of the fixed asset

without spending large amounts of cash to

purchase the asset.

The company eliminates the risk of owning

an obsolete asset.

The company may deduct the annual lease

payments for income tax purposes.

LO 4



Lease versus Capital Investment

One disadvantage of leasing a fixed asset is:

The leasing arrangement normally is more costly than the outright purchase of the asset.

LO 4



Uncertainty

All capital investment analyses rely on

factors that are uncertain.

Estimates of revenue and expenses

The amount of cash flows

LO 4



Changes in Price Levels

General price levels often increase in a

rapidly growing economy, which is called

inflation.

Price levels may change for foreign

investments. This occurs as currency

exchange rates change.

Currency exchange rates are the rates at

which currency in another country can be

exchanged for U.S. dollars.

LO 4



Qualitative Considerations

Improvements that increase quality and

competitiveness are difficult to quantify.

The following qualitative factors are

important considerations.

1. Product quality

2. Manufacturing flexibility

3. Employee morale

4. Manufacturing productivity

5. Market (strategic) opportunities

LO 4




Diagram the

capital rationing

process.



Capital Rationing

Capital rationing is the process by which

management allocates funds among

competing capital investment proposals.

LO 5



Capital Rationing

(continued)

LO 5



LO 5

Capital Rationing

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University



Capital Investment Analysis

The End

Documents

No Slide Title · capital investment analysis. 2. Evaluate capital investment proposals using the average rate of return and cash payback methods. 3. Evaluate capital investment proposals